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Inherited an IRA? Here Are Your Options

Choosing your approach wisely can help you avoid an unnecessary tax burden.
Feb. 6, 2018
Financial Planning, Investing, IRA
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When you inherit an individual retirement account, your options depend primarily on your relationship to the original account holder (i.e., if you’re a spouse or not) and whether you’re inheriting a traditional or Roth IRA.

Below are guidelines on the most common scenarios beneficiaries face. If you’re feeling overwhelmed by the nuances of these options, we recommend consulting a financial advisor to avoid unnecessary taxes or penalties.

Options for spouses inheriting a traditional IRA

You can take over the IRA (also known as a spousal transfer or “assuming” the IRA). When you assume an IRA you become the account holder, and the IRS treats it as though it had been yours all along. You can do this by designating yourself as the owner or rolling the money into an existing traditional IRA or workplace retirement account with the same tax treatment, such as a 401(k), 403(b) or 457(b).

All contribution and withdrawal rules that apply to your own tax situation, such as whether you’re eligible to put money in the account and when you need to start taking distributions to avoid incurring penalties, apply to the new IRA as well.

You can open an inherited IRA. If you’re a spouse but not the sole beneficiary, you’ll have to do this instead of assuming the IRA. The rules here are less flexible: Instead of taking over the account, you and everyone else who is named a beneficiary must establish separate inherited IRA accounts in your own names to hold your portion of the assets.

At this point you must choose exactly how you’ll inherit the IRA, which will affect how much money you’ll be required to withdraw over time. (We’re talking about required minimum distributions, or RMDs.) There are two options for how to set up distributions in the inherited IRA:

  • The “life expectancy” method spreads distributions over your remaining lifetime as predicted by the IRS’ life expectancy tables. (The rules are slightly different if the deceased has started taking RMDs.)
  • The “5-year” method gives beneficiaries five years after the year the account holder died to fully drain the account of assets and pay the taxes due. (See the IRS’ description of the 5-year rule.)

Failure to comply with the rules of RMDs could cause the IRS to charge a hefty penalty fee: 50% of the amount that wasn’t distributed. To get this part right, we encourage you to consult with the original source — the IRS FAQ on IRA RMDs — or a financial planner.

Non-spouses are not allowed to roll the money from an inherited IRA into an existing IRA.

You can renounce (or disclaim) the IRA. Just as it sounds, disclaiming an IRA means saying “no, thank you” to any claim on some or all of the assets within the IRA. People might disclaim an IRA if they want the money to pass along to a loved one (or entity, such as a charity) who has been named the secondary/contingent beneficiary, or if they want to avoid having to pay federal or estate taxes on the inheritance.

You can cash out the IRA. This is called a lump-sum distribution, and it comes with more potential consequences than the options above — see the section below on this.

Options for non-spouses inheriting a traditional IRA

You can open an inherited IRA. This means transferring the assets into a new IRA that you set up and formally name as an inherited IRA; for example, (Name of Deceased Owner) for the benefit of (Your Name). Non-spouses are not allowed to roll the money from an inherited IRA into an existing IRA. This also means no additional contributions are allowed.

For non-spouses inheriting a traditional IRA, it’s important to note that the IRS requires the beneficiary to begin withdrawing at least a minimum amount of assets fairly quickly — either by Dec. 31 of the year after the account holder dies (if you decide to use the life-expectancy method based on your lifetime or the deceased’s if they started taking RMDs) or up until Dec. 31 of the fifth year after your loved one died (via the five-year method where you’ve got that amount of time to empty the account). Miss the deadline and the IRS will sock you with a 50% tax penalty on the amount that is not withdrawn.

» See NerdWallet’s top picks for best IRA accounts

You can renounce (or disclaim) the IRA. If you don’t want to deal with any pesky tax issues or wish the money to pass along to the next beneficiary in line, you can refuse any claim on the assets in the IRA.

You can cash out the IRA. Called a lump-sum distribution, this comes with more potential consequences than the options above. See the next section for details.

Thinking of cashing out a traditional IRA?

Before you cash out an account all at once, consider the consequences of going with the “Vegas or bust” option: You will get a bill for taxes from Uncle Sam.

Withdrawals from a traditional IRA are taxable as income since the original account holder likely used pretax dollars to fund the account. If the amount you’re inheriting is sizable enough, it may bump you up to a higher tax bracket, which in turn may trigger a higher tax rate on the withdrawals.

On the brighter side, beneficiaries who go with the lump-sum option won’t have to pay the 10% early withdrawal penalty, even if they aren’t yet 59½ years old.

For detailed rules for beneficiaries of a traditional IRA, see the IRS’ publication 590-B. Click on “IRA Beneficiaries” in the table of contents to jump straight to the good stuff.

Options for spouses inheriting a Roth IRA

You can take over the IRA (known as a spousal transfer or “assume”). If you’re a spouse and the sole beneficiary of a Roth IRA, the IRS says you can treat the money as your own after you transfer the assets from the deceased’s account into your existing Roth IRA (or into a new account set up for this purpose).

If you’re the sole spousal beneficiary of a Roth IRA, you have the option of leaving the money untouched for as long as you want.

If you’re the sole spousal beneficiary of a Roth IRA, you have the option of leaving the money untouched for as long as you want. In other words, you don’t have to take required minimum distributions. (If there are other beneficiaries named, you’ll need to open an inherited IRA.) This is a plus if you want to use the account as a holding pen for money to pass along to loved ones since the money can be left undisturbed to compound and grow.

Beneficiaries who decide to start taking distributions benefit from the same rule that the applied to the original account holder: Withdrawals of contributions are tax-free at any time. But tread lightly when it comes to earnings: Withdrawing earnings from an inherited Roth before age 59½ from an account that’s not at least five years old will generally trigger an IRS bill.

You can open an inherited IRA. If you’re a spouse but not the sole beneficiary of the account, you may need to transfer the money into an inherited IRA that is held in your name. Other beneficiaries will need to do the same.

In this case, RMDs are mandatory, meaning you can’t let all the money ride and rack up earnings indefinitely. You can postpone distributions for a while — until the later of when the original account holder would have turned 70½ or Dec. 31 of the year following their death.

Required distributions can be paid out using either of these two options:

  • The life expectancy method, spread out over your lifetime based on this IRS table. Going this route allows any assets that aren’t distributed by the end of the required period to continue to grow tax-free.
  • The five-year method. You can take the money whenever you want during that five-year period, but assets must be distributed by Dec. 31 of the fifth year after the account holder died.

You can take a lump-sum distribution. You can simply withdraw the cash from an inherited Roth IRA, but there are potential tax implications here. Skip to the cashing out section below if you’re considering this.

Options for non-spouses inheriting a Roth IRA

You can open an inherited IRA. The beauty of a Roth IRA for the original account holder is that he or she is not required to start taking minimum distributions by age 70½ and can let the money continue to marinate in the account tax-free. That perk doesn’t transfer to non-spouses inheriting a Roth IRA.

If a family member or friend named you as a beneficiary on a Roth IRA, it’s generally mandatory to start taking distributions in a timely manner. First you’ll transfer the money into an inherited IRA held in your name. Next you’ll decide how you want to receive the payouts:

  • With the life expectancy method, you must start taking distributions by Dec. 31 of the year following the death of the original account holder. You won’t incur a 10% early withdrawal penalty, but you may owe taxes on earnings you withdraw that haven’t met the Roth’s five-year holding period rule. (Our Inherited Roth IRA RMD calculator shows how much money the IRS says you need to withdraw from the account.)
  • With the five-year method, the Roth must be fully paid out by Dec. 31 of the fifth calendar year after the year the owner died. You’re free to take them out at your leisure during those five years and, as with the life expectancy method, you’ll only owe taxes on distributions of earnings (not contributions) that have not yet met the five-year rule.

You can take a lump-sum distribution. It is possible to withdraw the cash from your inherited Roth IRA, but there are a few things you should know first. See the next section for details.

Considering cashing out a Roth IRA?

Cashing out an inherited Roth IRA has fewer unsavory consequences than cashing out an inherited traditional IRA. That’s because beneficiaries can withdraw contributions from a Roth IRA tax-free at any time. And as long as the account was open at least five years at the time the account holder died, earnings can be withdrawn tax-free, too.

Nor are Roth IRA heirs subject to the IRS’ 10% early withdrawal penalty by cashing in before age 59½ (the age at which Uncle Sam starts allowing retirement account withdrawals). But that doesn’t mean you’re necessarily completely off the hook with the IRS.

If the Roth IRA was less than 5 years old at the original owner’s death, no matter your relation to the deceased, you’ll owe taxes on the earnings (not the contributions) when taking a lump-sum distribution. So unless you have an immediate need for the money, it generally makes sense to roll the money into an inherited Roth IRA and take advantage of many more years of tax-free investment growth.

» See NerdWallet’s top picks for best Roth IRA accounts

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